Key takeaways
Despite recent market volatility, staying in cash poses additional risks
- With the drawdown and market volatility, some investors opt to stay in cash and wait until the ‘coast is clear’. Doing so introduces different types of risk into their investment portfolios.
- While stock volatility is the entry price to investing in the markets, stocks outperform cash in the long term. Waiting for the right time to invest risks missing out on some significant market returns. Cash also loses purchasing power due to inflation over time.
- Exposure to these risks of being in cash may leave investors behind in achieving their financial goals.
Uncomfortable market downturns – the price to pay for higher long-term return potential
After a powerful equity rebound in 2020 followed by an equally impressive return in 2021, investors were reminded in 2022 that volatility is the price of entry to the stock market. The rollercoaster equity market so far this year has pushed some investors to consider cash as an investment option or even try to time a better entry point into the equity market. Given the vagaries of market drawdowns and swings this year, staying in cash is tempting while waiting until ‘the coast is clear’. However, the weight of historical evidence demonstrates that cash is indeed not king and, in the long run, can be detrimental to investment portfolios, leaving investors behind in their planning goals..
Even though short-term volatility is a feature and not a bug in stocks, most annual returns historically have been positive. Moreover, this price of admission is well worth the long-term reward as the percentage of times the market has positive returns increases above 84% over three-year rolling time periods and beyond.
While temporarily going to high cash levels may make sense in certain situations, it’s important to recognize that cash is not a risk-free investment as purchasing power can erode due to inflation.
The histogram below shows that since 1926, stocks have been positive 74% of the time, or 71 years, while they been negative 26% of the time, or 25 years.
Risks of market timing
Market timing can be risky as waiting for the right opportunity to enter and exit the stock market can have its own risk. For example, just missing out on a few of the most important market days, which cannot be predetermined and therefore adequately timed, can actually be very costly to portfolios and make a big difference in the overall long-term returns.
In times of market volatility, some investors either increase their cash holdings or opt to stay in cash and wait for ‘the coast to clear’ before deploying that cash into the market. This market timing tactic also entails risk — the risk of missing out on some of the best return days, leaving investment portfolios behind in helping investors achieve their financial goals. Market rebounds off the lows in a volatile period can be unexpected and sometimes very strong. Investors risk missing out on those impactful up market days as they wait for the right opportunity. The chart below highlights such risks, where missing out on a handful of those impactful days can result in a meaningful lag in investment results compared to staying in the market for the total period.
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Chart describes S&P 500 intra-year declines versus calendar year returns.
Chart describes the percent of time U.S. stocks have positive return from a rolling 1-year bases to a rolling 20-year bases.
Chart describes the percent of time U.S. distribution since 1926. It indicates 71 positive years and 25 negative years.